Agenda: Compensation Linking Executive Pay to Performance

During the first three years say-on-pay rules have been in effect, shareholders have approved the vast majority of executive compensation plans. But that doesn’t mean compensation policies aren’t changing.

Under the rules, enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, public companies must give shareholders a chance to vote on executive compensation policies at least once every three years.

The rules have changed the type of compensation many executives get and opened a new line of communication with shareholders. Say on pay also has enhanced HR departments’ role.

"Say on pay really elevates the HR department’s visibility to the board and to their peers. The choices they are making have much more significant implications," says Blair Jones, managing director in the Utica, N.Y., area at Semler Brossy Consulting Group LLC.

Harvey Pitt, former chairman of the U.S. Securities and Exchange Commission, says shareholder oversight of pay decisions positively influences boards.

"Many boards don’t really go through the discipline of thinking about compensation and ‘How do we define what we want from a particular position, and how do we know we are getting what we pay for?’ " says Pitt, CEO of Kalorama Partners LLC, a Washington, D.C.-based consulting company.

David Wise, vice president and director of practice development, executive compensation, at Hay Group in Jersey City, N.J., agrees. "Directors are asking much harder questions about performance and about pay," says Wise, whose company advises on compensation.

Say-on-pay votes are nonbinding, so some critics argue that the rules have little impact. But compensation experts note that even companies whose pay proposals pass without strong shareholder support often make changes to their compensation packages. Say-on-pay proposals rarely receive less than 50 percent of the votes cast, but companies often interpret support of 80 percent or less to be a sign of shareholder unease. Companies know that pay is under the microscope now, so they aren’t waiting until there’s unrest among shareholders to start making changes.

Say on pay "has had the effect of getting rid of poor pay practices," observes Carol Silverman, a partner at Mercer LLC in New York City.

The following are some of the biggest changes taking place:

A higher percentage of executive pay is now linked to performance, based on measures such as income, profit and cash flow. In 2009, one-fifth of CEO pay was based on performance; now it’s 31 percent, according to Hay Group.

Pay incentives are more focused on long-term results. This year marks the first time long-term incentives have been the single heaviest component in CEO pay packages, according to Hay Group. Long-term incentives like stock options now make up about 61 percent of total direct compensation.

Companies have cut back on perquisites for executives, especially the types most likely to raise shareholder ire—such as cushy severance packages, tax gross-ups on golden parachutes, spousal travel, cars and security. Personal jets remain the most popular perk, though, and haven’t lost ground, Hay Group says.

Emotions and Returns

Say-on-pay rules require more disclosure about how much top executives—usually the top five executives and the board of directors—are paid, and the law requires that those disclosures be made in plain English.

But Pitt says understanding the intricacies of pay packages is still difficult. "I don’t know how many shareholders can exercise an intelligent vote on a pay package when they don’t have a lot to go on," he notes. "The votes are cast more on the basis of emotion."

A huge factor in whether pay packages pass muster with shareholders is the health of total shareholder returns, including dividends and stock prices. "That’s what the shareholders care most about," says James D.C. Barrall, global co-chair of the benefits and compensation group at law firm Latham & Watkins in Los Angeles. "What really annoys them is poor total shareholder returns. If the company hasn’t delivered, they are not very forgiving."

A 2013 study by Mercer shows that say-on-pay votes were closely tied to total shareholder returns this year. Of 1,700 companies, only 2 percent had pay proposals that failed their say-on-pay votes. The average total shareholder return at those companies was 5 percent the previous year, compared with a 24 percent return at companies that drew 90-plus percent shareholder support for their pay policies.

During the first three years of say on pay, total shareholder returns have been positive. It remains to be seen how votes might differ in a bad year, according to Irv Becker, Hay Group national practice leader, executive compensation, in Philadelphia.

Key Challenges

The real difficulty companies face under say on pay has been how to figure out if pay is aligned with performance, Barrall says.

The biggest issues HR officials and others grapple with are:

Defining the peer group of companies to use when comparing the company’s pay practices and performance.

Designing pay packages that drive specific performance goals.

Peer-group benchmarking has become a hot-button issue because some companies have been accused of handpicking comparators to make it easier to increase pay—by including larger companies in the peer group, for instance, Becker says.

Jones suggests that HR departments start by looking at the pay structure at other companies in their industry and the ones they compete with for talent. They should then narrow the group by the size of the business, since pay levels are generally higher at larger companies. A good rule of thumb is to choose companies whose revenues range from half to twice your organization’s revenue. Other factors can further narrow the peer group, such as domestic vs. international presence, online vs. brick-and-mortar operations, and specific niches. A children’s apparel business might not be comparable to a shoe retailer, for instance.

Those business characteristics aren’t always captured in the peer groups chosen by proxy advisors hired by shareholders to advise them on votes, so HR departments and boards need to spell out in disclosure forms why they chose a different peer group.

How will company leaders know that pay packages are driving business goals? Look at whether the packages have translated into total shareholder return, Barrall recommends. "The pay of the senior executives should bear some resemblance to what shareholders get out of their investment."

Thus, HR departments and boards need to work to create pay packages that will improve shareholder value. That can mean better earnings, sales, returns on capital, customer satisfaction or other measures, depending on the company. A 2013 study by Meridian Compensation Partners LLC showed that operating income was the most popular performance metric, with 42 percent of companies taking that into consideration.

Proxy advisors including Institutional Shareholder Services Inc. and Glass Lewis & Co. are looking closely at whether the goals used at most companies are aggressive enough to drive performance, Barrall says.

For a really successful company, Jones says, the performance goals may need to be set higher than at other companies, but the executive pay needs to be higher, too.

Research. HR departments should be versed in the pay practices of the companies in their peer group. "You help your [compensation] committee by understanding the context they are operating in," Jones says.

HR can dig into not only how much executives at peer companies are paid but also what metrics and types of pay are used in their compensation packages. General pay studies or custom studies can help, as well.

HR departments also need to delve into the compensation packages at companies that share board members with them.

Rationale. Say on pay has pushed companies to homogenize their pay practices because of the focus on comparing companies with each other, but that’s not always a good thing, Jones says. A poorly performing company that wants to improve its operations and revenue, for instance, may need to attract outside leaders, which can mean paying more than the median. And to retain jittery employees in an unstable environment, the incentives may need to be shorter-term than those used by other companies. At the same time, a highly successful company may need to pay people more to keep competitors from raiding its talent.

HR departments, Jones says, need to articulate their reasons for why trends in pay practices elsewhere don’t apply to their companies. "Strategies differ, so the metrics can and should differ by company," Jones says.

Silverman advises HR leaders to think about the policies behind the company’s pay practices and make sure they are sound for that company.

HR departments also need to show that responsible governance of their compensation program exists. For instance, Jones says, demonstrate that clawback provisions are in place. And when discretion is used to work outside the normal rules, resulting in higher compensation, show that objective measures—not favoritism—led to that leeway.

Reaching out. HR, with help from the legal and investor relations departments, needs to communicate well with both the board and the shareholder community.

HR should "ground the [compensation] committee in the philosophy of the compensation program and how that relates to the business strategy," Jones says. How do the performance metrics used to evaluate executives, for instance, link to the company’s strategy?

Reaching out to shareholders can also help HR to communicate with the committee. "The more you understand the issues your investors care about … the better equipped you’ll be to guide your compensation committee," Jones says.

Becker also advises companies to communicate regularly with shareholders about compensation.

Many companies that get less than 70 percent shareholder support for their pay policies now routinely contact their top 20 or 30 shareholders after proxy season and get feedback on what needs to change, according to Barrall. "If you have a failed vote or a low vote, you are going to continue to be in trouble unless you respond fairly aggressively."

A 2013 Towers Watson study of companies that received shareholder support of less than 80 percent for their pay packages in 2011 or 2012 found that 72 percent of them reached out to shareholders to talk about the proxy vote afterward. More than two-thirds changed their compensation plans.

This combination of communicating and addressing investors’ concerns seems to be helping pave the way for better say-on-pay results. Mercer’s study found 12 companies whose pay proposals failed in 2012 but passed overwhelmingly this year with more than 90 percent of the vote. The companies took actions like strengthening the link between pay and performance and improving disclosure about pay practices.

Overall, Barrall says, the new rules likely haven’t driven down pay—Hay Group found that overall pay levels stayed fairly steady in the past year—but companies have changed the pay mix so that more of the compensation is based on performance and more is tied to long-term incentives.

Business cycles make it hard to determine whether say on pay has affected the performance of companies, "but I think it’s been a good thing for pay and governance practices," Barrall says.